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Maxim Integrated Products (NASDAQ:MXIM)

F1Q07 Earnings Call

November 1, 2006 5:00 pm ET

Executives:

Carl Jasper, Vice President of Finance and Chief Financial Officer

Jack Gifford, Chairman, President and Chief Executive Officer

Tunc Delugha, Group President

Peruz Pavarande, Group President

Allen Hill, President of Dallas Semiconductor

Analysts:

Adam Parker, Sanford Bernstein

Michael Masdea, Credit Suisse

Craig Hettenbach, Wachovia Securities

Simona Jankowski, Goldman Sachs

William Lewis, JP Morgan

Doug Freedman, AmTech Research

Sumit Dhanda, Banc of America Securities

Chris Caso, Friedman Billings Ramsey

Jeff Rosenberg, William Blair and Co.

Craig Ellis, Citigroup

David Wu, Global Crown Capital

Louis Gerhardy, Morgan Stanley

Ross Seymore, Deutsche Bank

Tore Svanberg, Piper Jaffray

Ramesh Misra, CE Unterberg

Operator

Thank you for standing by. Good day and welcome to the Maxim Integrated Products First Quarter 2007 Earnings Release Conference Call. Today’s call is being recorded. At this time, for opening remarks and introductions I will turn the call over to Mr. Carl Jasper, Vice President of Finance and Chief Financial Officer for Maxim Integrated Products. Mr. Jasper, please go ahead.

Carl Jasper, Vice President of Finance and Chief Financial Officer

Thank you, operator, and again welcome to our first fiscal quarter 2007 earnings conference call. With me on the call today are Jack Gifford, our Chairman, President and Chief Executive Officer, and our two group Presidents, Tunc Delugha and Peruz Pavarande. Also on the call are Alan Hill, Vice President of Dallas Semiconductor, and Paresh Maniar, Director of Investor Relations.

There are some administrative items that I would like to take care of before we cover our results. First, we will be making forward-looking statements on this call and in light of the Private Securities Litigation Reform Act, I would like to remind you that statements we make about the future, including our intentions or expectations or predictions of the future, including but not limited to possible statements regarding bookings and turn orders, revenues and earnings, inventory and spending levels, manufacturing efficiencies or capacity, projected in-market consumption of our products, and any other future financial results are forward-looking statements.

If we use words like anticipate, believe, project, forecast, plan, estimate or variations of these words or similar expressions relating to the future, they are intended to identify forward-looking statements. It is important to note that the company’s actual results could differ materially from these projected in the forward-looking statements. Additional information about risks and uncertainties associated with the company’s business are contained in the company’s SEC filings on Form 10-K for the year-ended June 25, 2005. Copies can be obtained from the company or the SEC.

Second, and keeping with the SEC’s fair disclosure requirements, we have made time available for a question and answer period at the end of today’s call. This will be your opportunity to ask questions of management concerning the quarterly results and expectations for next quarter. An operator will provide instructions at that time.

I’ll begin today’s call by commenting on our financial performance before handing the call over to Jack, Tunc, and Peruz for their comments on end markets, strategies, and guidance for the second quarter of fiscal 2007.

Net revenues for the first quarter were $503 million, down 1.5% from the fourth quarter and up 18.5% from the same quarter last year. Gross turn orders during the first quarter were $233 million, of which $139 million was shipped for revenues within the quarter. For comparison purposes, turns for the fourth quarter of fiscal 2006 were $251 million of which $166 million was shipped for revenues within the fourth quarter.

First quarter GAAP gross margins came in at 63.9% compared to the fourth quarter gross margin of 66.3%. Approximately 1% of the first quarter decrease in gross margin was due to booking additional inventory reserves, 0.5% due to the mix shift to higher volume products which carried lower gross margins, 0.4% due to the retention grant of RSUs made to manufacturing personnel, and 0.5% to the one-time benefit received in the fourth quarter from one of our vendors.

Operating expenses were $170.3 million in the first quarter compared to $165.1 million in the fourth quarter. The increase in spending was primarily related to $3 million associated with the review of the company’s option program and historical option grants, and $3 million for additional head count and related spending in research and development.

Our tax rate for the first quarter was 34.7% compared to 32.7% for the prior quarter. This increase in the tax rate was first due to the old tax deduction for extraterritorial income being eliminated and replaced with a deduction for domestic production that is being phased in over several years, and secondly due to the U.S. government’s failure to reinstate the R&D tax credit.

Earnings per share was $0.33 per share, in line with the updated guidance given for the first quarter. With the investment community having moved to GAAP accounting on stock option expensing much sooner than anticipated, we feel that Maxim’s stock price and consequence to our most loyal shareholders are being penalized due to the comparison of our GAAP earnings versus those companies with accelerated stock options prior to the adoption of FAS 123R. Had we accelerated divesting out of the money stock options upon the adoption of FAS 123R, our earnings per share during the first quarter would have been approximately $0.033 higher.

I will now highlight a few items on our balance sheet. Accounts receivables decreased $0.8 million during the quarter to $291.7 million. Our day sales outstanding or DSOs increased slightly from 52 days in the fourth quarter to 53 days in the first quarter. Our inventories grew as planned by $10.6 million during the first quarter ending at $207.9 million. Inventory days remained fairly consistent at 109 days compared to 110 days in the fourth quarter. Inventories at our distributors were up during the quarter but continued to turn approximately 7 times on an annual basis. At the end of the first quarter, cash and short-term investments totaled $1.4 billion, up $52 million from the fourth quarter.

Regarding the use of cash, we utilized $60.8 million to repurchase 2.1 million shares of our common stock, paid out $50 million in dividends during the first quarter, and paid $94.9 million for property and equipment.

We have previously issued press releases regarding derivative law suits filed against certain former and current officers and directors alleging wrongful back dating stock options to certain officers and inquirers by the SEC and the U.S. Attorney and to our past option grants and granting practices. We have also issued a press release regarding the delisting notice we received from NASDAQ and are intent to appeal this process. Due to legal constraints, we will not be making any additional comments on this issue either during the prepared remarks or in the Q&A portion of this conference call.

I will now hand the call over to Jack to provide additional highlights.

Jack Gifford, Chairman, President and Chief Executive Officer

Thank you, Carl. At our analyst meeting in May of this year, we outlined the five strategies that drive our long-range plan and I believe they will take us above industry revenue and earnings growth. I’d like to take some time to review these strategies with you and our progress in executing.

Our first strategy, as some of you will remember, is to focus on defining and pursuing high-value added large markets. Our goal is to leverage our strengths such as our high performance design capabilities in these markets. We’ve already achieved significant success in a number of high-volume markets such as digital cameras and flat panel displays, and Tunc and Peruz will be taking briefly about some of these successes later in the call.

Our second fundamental strategy is to partner with major electronic manufacturers. I know most of you are aware of that and have a lot of questions and comments on that. Just a few years ago Maxim supplied a very small portion of the semiconductors that these top 20 IC consumers purchased each year. Our concentrated efforts to cultivate these large users have begun to pay off. Design wins followed by good execution has opened doors for us to supply products for additional sockets in a vast range of equipment that these companies make.

The portion of our revenue that comes from these top users of integrated circuits has grown from 28% in fiscal ’04 to 34% in ’06, which is a 55% increase in sales to these top customers over that two-year period. Although the percentage of our revenue from our top 20 customers will continue to rise, none of these OEM customers represents more than 6% of our revenues today.

Our third fundamental strategy to strengthen our core technical competencies. Maxim is one of the most prolific inventors of new analog and mixing ICs in the world. This results from the use of our broad high-performance cell library. We are continuing to generate library cells that are only available at Maxim for design of complex performance, high-performance customer solutions as well as being sold as standalone combos in the cellphone.

This is a very significant proprietary advantage that Maxim holds over almost all of the analog companies. We continue to develop new processes and packaging technologies necessary to successfully realize these high-performance components and application specific integrated circuits. Foundries and most of our competitors cannot offer these combined technologies.

Our core strategy is to maintain our in-market diversity. Even as we have pursued strategic high volume opportunities, and no single end equipment segment represents more than 15% of our business. We are targeting our R&D efforts at over 18 different in-markets as we continue to seek out opportunities in growth in emerging applications. We’re constantly looking for the next emerging iPod or satellite radio. Maxim today supplies product into virtually every in-market that uses complex analog integrated circuits.

Our fifth and last strategy, and clearly this is important as any of the other four, is to attract and retain our talented employees. In an environment where a number of companies are competing for scare mixed signal analog engineers in all facets of engineering from circuit design to product engineering, Maxim has been a net add of engineers every quarter. Lack of growth in technology stock prices has created more than historical mobility in our industry, but I believe that we have fared as well as anybody and probably better than most during these most volatile times.

As we have noted previously, high-volume markets may provide somewhat lower but still attractive gross margins. A popular misconception, however, is that lower margins are due to a greater competition for these sockets, and in reality the reverse is true. Many companies can produce lower complexity, lower performance analog ICs, but very few have the necessary analog and digital functional performance in their cell libraries to provide high-performance and highly integrated solutions, which these major corporations require. These enable our customers to build products that are smaller, thinner, lighter, more feature rich, making design wins, achieving this approach, very high proprietary for Maxim.

High volume integrated circuit gross margins are heavily influenced by the price that our customers’ equipment can afford. For instance, a cellphone manufacturer wants to add a TV reception feature to his next-generation phone knows that the consumer would only be willing to pay a certain premium for that feature. By working backwards the customer determines how much he can afford to pay for the components to add that feature. Maxim must then decide whether the margins are accretive enough for us to pursue this opportunity, either as a standalone function of our integrating or the TV reception capability with other functions that we supply in the phone.

Typically, the gross margin that the customer can afford to pay for such an added functionality is not 80%. However, the R&D that goes into supplying such a function can spread over a far larger number of units. The impact of the lower gross margins can be mostly if not entirely offset by the leverage in below-the-line spending. These are decisions our management makes regularly, and most importantly we get to make these decisions before we commit to development enabling us to be in better control of our gross margins.

Then, why are we adding this complexity and risk to our business? Simply because this is a safest growth opportunity for Maxim. To maximize Maxim’s profit growth rate we must expose ourselves to these opportunities and their risks. It is more risky, however, to stay in the comparatively crowded low-complexity, low-volume markets than the safer high-value, less competitive, and more difficult complex chip markets.

Executing these strategies is not without growing pains as some of you know and we know. Having said that, we are aware of the concern in the investment community regarding the rate of decline of our gross margins. We have extensively reviewed all aspects of our business dealings with the execution of our core strategies, and from that comes a list of identified issues and actions underway now at Maxim to correct and control our profit quality. I would like to go through these with you briefly.

First, in the past all products in development were management by the same metrics, whether it was complex or simple. We now have separated our products into two classes: complex and noncomplex. Complex products total approximately 25% of the products in development at any given time at Maxim. Complex products targeted in volume applications now get significant more focus from the executive management than devices that have less technological and less gross margin risk.

The progress of each complex product is now reviewed monthly at my level and Tunc and Peruz’s level with the owner of the product, and that is a business unit executive. This review will ensure improved manufacturing ability and gross margin control. During the development phase we continuously monitor parameters such as the competitive environment, validation of customer required samples, sample schedules and pricing, and the general management commitment of the sponsoring customer. This is the responsibility of each business unit executive, and not a subordinate. The business unit executive will work to control these parameters along with cost assumptions and will be gaining introductions to ensure those products are manufacturable at acceptable margins and volumes consistent with customer production ramp requirements. Exception products, products that don’t meet those requirements will require a group president to buy off.

Secondly, the price at which a new product is offered to a customer historically has been determined by a business unit personnel at lower levels in the company. Due to the wide dispersion of our revenues from thousands of products, pricing an individual device has minimal impact on company wide margins, with our growth in high-volume markets and find that the mispricing of complex large revenue products can have a significant impact on corporate margins, especially if customer productions volumes ramp before expected cost savings are realized. We have elevated the responsibility for pricing of complex products to the business unit executive level, requiring presidential approval in many cases. For already introduced products where pricing has resulted in unacceptable gross margins, we are selectively raising prices when it is prudent without damaging customer relationships. In the short term, this will have limited effect in gross margin approval. Going forward, however, we believe these pricing areas will be eliminated.

Thirdly, in our traditional markets products have slower ramps and longer life cycles. This gave us time to optimize yield and manufacture ability. In the fast and ramping high volume markets it has become clear that cost reduction has to be a higher priority and turned much earlier. We are working aggressively to improve cost for a number of introduced products that did ramp before yields and costs were aligned with profit objectives. Again, future complex products will be cost and yield improved to meet their profit objectives before the product is announced.

Fourth, for many analogs ICs test and packaging cost are a significant portion of the manufacturing cost. The optimization of product test cost and in some cases has been given necessary priority as the product rapidly transitions from development phase to large volume manufacturing. Testing inefficiencies can also result in cost increases until the product test program is optimized. Introduced products that should benefit from test development have been identified and the necessary actions are being taken. Future fast ramp large volume products will be routinely targeted for test authorization before production volumes.

Fifth, when a product is in development, it’s testing is done onshore to facilitate a review analysis and on-time introduction of the product. Testing is transferred offshore in due course resulting in a significant reduction in costs. We are finding that fast ramping, high volume products need to be transferred offshore and much faster to quickly maximize their gross profit contribution.

Test systems are being installed offshore for the transfer of complex products that are currently being tested onshore. The expeditious offshore transfer of fast ramp, high volume products is now a part of our new complex product introduction procedure.

And finally, we are examining our product lines through identified products that do not support acceptable margins and do not fit into our strategic goals for long-term profit. Strong revenue growth provides us the best opportunity to leverage below-the-line spending. Maxim’s revenue growth will resume over the immediate term as a result of these strategies.

I should point out that since the strategy to address high volume markets started to kick in a year ago, our revenue growth has surpassed that of our closest peers. We are now attacking the second phase of this strategy. We are working to ensure that our execution allows us to extract the maximum accretive profit that these markets offer to us. The potential for problems discussed probably should have been identified as a subset of our strategies, i.e. the need for a bimodal new product management system to deal with these complex high-volume products. We now have one and it is now in place.

During the past quarter, we have introduced a number of groundbreaking products, many with high levels of integration. To provide a commentary on the first quarter in-market activities and key products that we introduced during the first quarter I’d like to turn this call over now to Tunc first and then Peruz to close.

Tunc Delugha, Group President

Thank you Jack. After six straight quarters of bookings increases, during the first quarter we experienced an order rate decline. During the quarter, we recorded $507 million in gross bookings, a 9% decline from the $557 million level of the previous quarter. Approximately $40 million of the reduction was due to customers placing their orders closer to the requested ship date by one week, and another $7 million of the decline was due to one customer changing its order to adjust-in-time format.

Worldwide, distributor bookings on Maxim during the first quarter were lower than the orders that they received for Maxim parts from their customers by about $20 million. This implies distributors were reducing their inventory during the quarter. Bookings from 4 of our end equipment markets were up and 15 were down. Geographically Japan and Korea bookings were up while the other four regions were down.

We believe over ordering in the fourth quarter to ensure fourth quarter and the first quarter shipments was the major factor. Our 12-month backlog declined to $415 million at the end of the first quarter compared to $429 million at the end of the fourth quarter. Our beginning 90-day backlog for the second quarter is $365 million, relatively unchanged from the beginning 90-day backlog for the first quarter of $366 million. We currently expect second quarter revenues to be flat to 4% below the first quarter level.

Now, I’d like to describe a few of the exciting end equipment opportunities, design wins, and a sampling of the new products we’ve introduced during the first quarter from the portable computing and instrumentation electronics group I am responsible for. Our new wide LED driver product lights up to 60 LEDs for flat panel liquid crystal displays or LCDs, enabling compact size and exceptional dimming range. This product is an Intel reference design for notebook computers.

Speaking of notebook PCs, we are now benefiting from the newly announced AMD-Dell relationship with Maxim DC-DC converters power AMD processors. We introduced digitally programmable gamma reference generators for liquid crystal displays, and this product has been designed by a top LCD manufacturer. It is a critical component to compensate for non-linear color response of LCDs resulting in enhanced color and faster response time for computer monitors and flat panel televisions.

Maxim’s new CDMA cellphone power management IC was announced and simultaneously designed in at a top tier phone maker with volume production starting in the next three months. This is an example of one of these fast ramp products. The product is a complete power supply loaded with exclusive features like a 30-volt charger input and 4 MHz switching frequency providing small solution size. These features are the result of proprietary devices available from our in-house process technology.

Our newest DC-DC converter supplies the transmit power amplifier in CDMA and UMPS cellphones. It features the lowest resistance bypass switch available and improves conventional RF power amplified efficiency by almost 50% permitting longer talk, file transfer, and internet browsing times for third-generation handsets.

Just announced, our bidirectional video filter products allow designers the flexibility of recording and playback from a single connector in mobile consumer devices. By using the same filter in both playback and record modes, Maxim has the cost and space in personal media players such as video iPods. Additionally these devices have implemented Maxim’s Direct Drive technology to eliminate AC coupling capacitors and enabling thinner players. Maxim’s 3 Amp and 10 Amp DC-DC converters with on chip power MOSFET switches as well as high-frequency DC-DC controller achieved significant design wins at commercial and enterprise network switches and routers at a major networking customer.

One of our business units, the Automatic Information Business unit, captured a design win that will be worth over $50 million in the coming years. It is another win in the area of medical consumable authentication, which has been an extremely successful area for our proprietary one-wire products. The design wins in this area are characterized by very high volumes and very long product life cycles.

Maxim has the largest share in the cellular mobile TV tuner market in Japan, with our ISDB-T2. Maxim ships most of the cellular TV tuners in the world. The top Japanese cellular phone companies have all told us our tuner has by far the best overall performance, a must for this technically challenging application. With our software GPS partner we’re now in production inside a USB attachment that turns a notebook computer into a full GPS car navigation unit. Our receiver product eliminates the need for the GPS base time chip for lowering cost and shrinking the solution size. This should be the first of many design wins for this new software GPS architecture.

Last but not least, Maxim won EDN China product of the year 2006 with a direct conversion transmitter chipset. This highly integrated low-noise, high linearity, direct up-conversion, down-conversion modulator-to-modulator is designed for RFID handheld and portal readers as well as single and multi-carrier GSM EDGE, CDMA, wide band CDMA, and iDEN base station applications.

I will now hand over the call to Peruz to discuss developments in his business units.

Peruz Pavarande, Group President

Thank you Tunc. As Tunc noted in his remarks, I also see exciting growth opportunities in many different application areas. I’ll briefly elaborate on a few of our new product introductions in the multimedia, automotive, and telecommunications electronics group that I’m responsible for.

Last quarter, we introduced a controller monitor for transceivers used in passive optical networks. This high-growth technology brings wideband with voice, data, and video services to the home. This devices integrates all of the control and data acquisition circuits needed to realize a passive optical network transceiver. Additionally, it provides a simple way to adjust the power output of each unit to compensate for the variable fiber length to the hub, which enables a lower cost design to be used for the network receiver.

We introduced a number of innovative products for emerging applications that use high brightness LEDs to the light systems. One family of products incorporates the highest integration LED drivers for LCD backlighting applications. These drivers have an ultra wide dimming ration that makes them ideally suited for automotive applications.

Another family of products utilizes the Maxim invention that will enable projector manufacturers to replace the high intensity discharge lamps in their current systems with high-power LEDs to improve color quality and light source reliability.

I’m also pleased to report that we’ve received significant design wins in notebook platforms with our Windows Vista compliance speaker and headphone amplifier product. This product uses Maxim patent for technology to eliminate bulky external components and its high performance allows a comfortable margin that simplifies the system design.

In closing, we’re pleased to announce that during the past few weeks, Maxim has achieved preferred supplier status at two of the world’s top 20 consumers of ICs. Reaching this most favored vendor level is further evidenced and our major account focus is working.

I’ll hand it over to Carl.

Carl Jasper, Vice President of Finance and Chief Financial Officer

Thanks, Peruz. That’s the end of our prepared comments. We would now welcome your questions. Operator, will you please begin polling for questions.

Question-and-Answer Session

Operator

Ladies and gentlemen, if you have a question at this time please press the 1 key on your touchtone telephone. If your question has been answered and you wish to remove yourself from the queue, please press the # key. Our first question comes from Adam Parker from Sanford Bernstein, your question please.

Adam Parker, Sanford Bernstein

Hi, I heard you said the revenue for December was flat to down 4, but could you provide gross operating or earnings guidance at all for December, why the change in strategy?

Jack Gifford, Chairman, President and Chief Executive Officer

Well, it has to do with the range of guidance for one and also the earnings per share which require that we have a handle on below-the-line spending, which we’re not sure where that’s going to quite end up.

Adam Parker, Sanford Bernstein

So, there’s more uncertainty this quarter than there has been in the past where, as you guys have always given the guidance in more detail?

Jack Gifford, Chairman, President and Chief Executive Officer

We could give you a range. I think you can probably figure out that as well as we can from the revenue guidance. I don’t want to give you a one number and that’s why we didn’t…

Adam Parker, Sanford Bernstein

Do you expect and SG&A dollars to be up sequentially in the December quarter?

Jack Gifford, Chairman, President and Chief Executive Officer

No, we don’t expect them to be up, but we can’t tell you how much they’re going to be down.

Adam Parker, Sanford Bernstein

Okay, but you expect absolute dollars for both R&D and SG&A to be down sequentially?

Jack Gifford, Chairman, President and Chief Executive Officer

That’s not what I said. I said they’re not going to be up but we cannot judge whether they’re going to be flat or down, because it’s a moving target.

Adam Parker, Sanford Bernstein

All right. The other question I have to get off that topic is, you talked about your share growing over the last few quarters than some of your peers, and you’ve talked a lot in the past about you have kind of two businesses where the older one maybe going at some rate like 10% and the newer one growing at some rate like 20% or 30%, can you talk about your complex versus noncomplex bookings or sales; I mean how are those things looking, are the high volume applications looking much better right now, or is it kind of consistent with the slow down across both areas?

Jack Gifford, Chairman, President and Chief Executive Officer

Peruz, you should also comment also. My view of that is that the bookings are better in the complex product areas than they are in the traditional lower complexity areas. I notice that our industrial bookings were down last quarter materially. So, I think some of the gross margin deterioration was due to mix change and I think that had to do with some of the more complex products growing and the less complex products not growing, so our mix is probably hurting our gross margin and the fact that the mix of less complex products, that ratio has gone the wrong way.

Adam Parker, Sanford Bernstein

All right, we’re seeing right now the revenue growth versus the peer, this is as wide as its going to get or do you think it continues to widen over the next couple of years?

Jack Gifford, Chairman, President and Chief Executive Officer

Say that again.

Adam Parker, Sanford Bernstein

I’m just trying to figure out, when do you think we’ll be seeing the maximum amount of revenue growth you’re getting versus some of the companies you are typically measured against, is it a year or two off in the future or do you think you’re seeing a lot of that already?

Jack Gifford, Chairman, President and Chief Executive Officer

I’m not sure I got the question, can you try it one more time for me?

Adam Parker, Sanford Bernstein

Sure, so you’ve talked about the fact that some of these high volume, more complex applications are going need you to grow faster than some of your traditional peers and you said you’re starting to see some of that incremental revenue growth versus the peers in the last few quarters, and I’m trying to figure out if you think you’re seeing the full effect of that now or if you think this complex business is going to become a larger and larger percentage of your revenue over time so that you’ll see more growth versus the peers a couple of years from now than you’re seeing now?

Jack Gifford, Chairman, President and Chief Executive Officer

Okay, I’m going to answer it, but I’m also going to have Tunc and Peruz commenting on that. My view is we have not see anywhere near the peak rate for two reasons: one, we have just basically been able to penetrate these major accounts and be important to them and not all of them yet. And secondly, our execution has not been as good as we would have liked. So, I see much more opportunity for growth rate increases going forward than in the past.

Tunc Delugha, Group President

No, I agree with Jack, we have not seen yet because if you look at the percentage of our revenue coming from high-integration products, it’s somewhere in the order of 10% to 15% and we project that to get to 30% to 40% in the next three or four years. So, the real growth is ahead of us.

Adam Parker, Sanford Bernstein

Okay, all right, thanks.

Jack Gifford, Chairman, President and Chief Executive Officer

Also, Tunc, don’t you guys want to comment on the…

Tunc Delugha, Group President

Yeah, on your previous question, we did see a lot of growth in the complex product area especially in my business units which are more heavily geared towards high-end consumer products. A lot of the design wins and a lot of the revenue growth in the last quarter did come from these high-integration type products, things like cellphones, cameras, and they all are very high integration products, smart batteries, all of them.

Peruz Pavarande, Group President

So, the growth that I did see in our business units came primarily from the consumer segment of cellphones and MP3 players and PMP type products, portable electronic devices. And part of that growth was driven by higher complexity devices but also the growth was also driven by some of the innovations that we had in those areas where we clearly had advantages over our competition through some of the inventions that we’ve made.

Operator

Thank you. Our next question comes from Michael Masdea from Credit Suisse, you’re question please.

Michael Masdea, Credit Suisse

Yeah, thanks a lot. Jack, you talked a lot about what you’re doing on the gross margins side overall in terms of some of the focus on your business and for some of these processes, etc., is there something that we should to think about your long-term gross margin target changing or should it be some impact and what’s the timeframe for that?

Jack Gifford, Chairman, President and Chief Executive Officer

Actually we’ll change, we don’t believe that this deterioration of gross margin will continue at that rate. We believe next quarter that our gross margins will probably drop half a point, but what’s gone in the last two or three quarters in our view is abnormal. We understand the causes and we’re doing a lot of things as I’ve outlined to remedy those things. So, we expect to be back to a much more normal gross margin from our business. As I said for a long time, we expect that we should be able to operate this business in the low-to-mid 60 gross margin levels at $5 billion to $6 billion level, and we still believe that.

Michael Masdea, Credit Suisse

And similarly we’ve seen operating margins fall right with it, is there anything that you’re thinking about doing on the spending side structurally or is it just a matter of getting the revenues where they need to be?

Jack Gifford, Chairman, President and Chief Executive Officer

It’s the revenue Michael. The gross margins are important if they stay at acceptable levels, but the key to our strategy and to our plan is to have better than market average revenue growth, which we believe will happen and we believe we are executing good in that area.

Michael Masdea, Credit Suisse

And then, just last one for me. If you look at what’s happening in the supply chain and lead times, etc., can you just give us your take on whether we are really seeing a sort of demand correction here, is there some risk of that or if this is purely just supply chain adjustments going on?

Jack Gifford, Chairman, President and Chief Executive Officer

I will comment and also and so will Tunc and Peruz on that. My view is that from my analysis our bookings were down from the fourth quarter to first quarter primarily because of over ordering in the fourth quarter, which was brought about by, one, they needed product to bill for the holiday season, and secondly they were concerned with lead times and ordered accordingly based upon on their expectation of our lead times. So, I believe that the first quarter bookings were somewhat aberrational relative to consumption rate, and I believe that that will correct itself in the coming quarter.

Tunc Delugha, Group President

Yeah, as I said in my part of the talk, I mean essentially the customer has given lead times to us reduced by about a week, and that had a lot to do with it going forward where that’s going to stabilize.

Michael Masdea, Credit Suisse

And where your lead times are now, is that impacting them still?

Jack Gifford, Chairman, President and Chief Executive Officer

Our lead times, Mike, came in about a week and a half but they still are longer than the customers are requesting but not by…I think they maybe a week longer than they are requesting. We think that our customers’ reaction to our lead times probably contributed to as much as $40 million of bookings or the lack of bookings.

Michael Masdea, Credit Suisse

So, does this mean you build inventory again and try to bring those lead times in further or is that guessing game is still too hard to bring this in?

Jack Gifford, Chairman, President and Chief Executive Officer

Mike, we build more product than we shipped in the first quarter. The problem is the mix and just getting the mix correct and getting it has been extremely difficult based upon the visibility we’ve gotten from customers. So, if we can build in mix, I think it would be better.

Michael Masdea, Credit Suisse

Got it, thanks a lot guys.

Operator

Thank you. Our next question comes from Craig Hettenbach from Wachovia Securities, your question please.

Craig Hettenbach, Wachovia Securities

Yes, thanks. Can you talk about the linearity of bookings as you progressed through the September quarter and then into the month of October here?

Jack Gifford, Chairman, President and Chief Executive Officer

Well, we’ve said in the last couple of calls that we didn’t want to extrapolate quarter bookings based upon four weeks of bookings, and I’d rather not do that. I will tell you that September bookings were not good. They were very low.

Craig Hettenbach, Wachovia Securities

And then in terms of the strategy of driving high volume business at top OEMs, you mentioned digital cameras a number of times where you’re having some success, can you give us some other examples where you are starting to see that design activity pick up in areas where you think you’ll drive some growth into calendar 2007?

Tunc Delugha, Group President

Other examples that we’re targeting and winning designs, we have some in handsets, we have some in media players, we have some in flat panel displays.

Peruz Pavarande, Group President

We have automotive design wins, new areas for us, also on the networking and datacom space as well.

Craig Hettenbach, Wachovia Securities

Okay, and for some of the consumer related ones will it really be towards the end of next year in terms of seasonal factors that you’d see, kind of a larger impact as those products would ramp seasonally.

Jack Gifford, Chairman, President and Chief Executive Officer

I don’t think so; I mean consumer product television, that’s another area we’ve had success getting designed into, digital televisions, flat panel televisions; I mean I think there is a year end peak but we don’t think of it as a big bubble.

Craig Hettenbach, Wachovia Securities

And then lastly if I could on the inventory front, in addition to running some dye banks for general purpose products, any change to how you’re structurally running manufacturing in terms of inventory and need the support for some of these newer higher volume applications?

Jack Gifford, Chairman, President and Chief Executive Officer

Buffer inventories I think these customers request, which means you’re building an anticipation of when they’re going to buy, and that’s also necessary because they do ramp really rapidly. But, no, we’re trying to add wafer fab capacity right now and we now are ahead of the curve, barely caught up, but we’ll continue to add capacity this quarter and increase our output, and then depending upon what happens to bookings this quarter, we will either flatten out or continue to grow on output.

Tunc Delugha, Group President

Also, for some of these high volume products, we’re looking at how to reduce cycle time. That helps us too.

Jack Gifford, Chairman, President and Chief Executive Officer

Yeah, that helps a lot. But we’re not sitting here anticipating a slow down if that’s part of your question, it’s not our frame of mind right now.

Craig Hettenbach, Wachovia Securities

Got it, thank you.

Operator

Thank you. Our next question comes from Simona Jankowski from Goldman Sachs, your question please.

Simona Jankowski, Goldman Sachs

Hi, thank you very much. First, I just wanted to clarify the comment you made, Jack, on the gross margins for next quarter being down 50 basis points or so, did you mean that to be down from the actually reported GAAP number this quarter or excluding the $5 million inventory one-time adjustments?

Jack Gifford, Chairman, President and Chief Executive Officer

That’s 0.5% would be on the GAAP numbers that you see reported.

Simona Jankowski, Goldman Sachs

Okay, so it will be more like 1.5% of the actual x inventory adjustment number?

Jack Gifford, Chairman, President and Chief Executive Officer

Yeah, I mean you always have reserve requirements that you have to analyze every quarter, but again it’s off of what we reported last quarter, that’s a 0.5% drop.

Simona Jankowski, Goldman Sachs

Okay, and then maybe just to put inventory reserve in context, you called out this quarter and I think it’s something that happens every quarter, was this just a larger amount this time around or was it just on a discontinued product line or can you just give us a little more color there?

Jack Gifford, Chairman, President and Chief Executive Officer

Overall, it was bigger, it was more.

Simona Jankowski, Goldman Sachs

So, the typical would be more like $1 million or 2 million or something?

Jack Gifford, Chairman, President and Chief Executive Officer

Yeah, that’s typical. This quarter was just a little bit more and that’s why we called it out.

Simona Jankowski, Goldman Sachs

Okay, and can you give us a little more color on what was behind that?

Jack Gifford, Chairman, President and Chief Executive Officer

Basically, there were on products that we did not see a demand for over the next four quarters and we have policies that say that we need to write off excess inventory. Now, whether the customers come and buy it is another question, but it was the policy that determines the size of that reserve and its product, where you have product and you do not project that you will consume it over the next four quarters.

Simona Jankowski, Goldman Sachs

Okay, so it was one of the newer, more complex, higher volume products?

Jack Gifford, Chairman, President and Chief Executive Officer

No, I wouldn’t say that, it’s a mix of products. I mean I wouldn’t say it ties the complex products at all, it’s just across the board. We got simple products that we don’t forecast right either or customers don’t buy.

Simona Jankowski, Goldman Sachs

Okay, thank you for that clarification and then just the another thing I wanted to ask about is, I think it was Peruz who mentioned that percentage of your sales that are driven by the complex products now is in the 10% to 15% range, and I just wanted to see how you think you are relative to the targets you had shown at the analysts day, I think that was for about a 25% of sales in fiscal ’07 from ASSPs and I’m not sure if that’s the same definition or not, but just wanted t check in on the progress to that target.

Tunc Delugha, Group President

I don’t remember the exact number, I don’t have it in front of me, but in general I know from the business units that we are on target in terms of launching and getting those types of products into production.

Jack Gifford, Chairman, President and Chief Executive Officer

I think the number he used…that’s the current revenue from those products.

Simona Jankowski, Goldman Sachs

Okay, terrific, thank you very much.

Operator

Thank you. Our next question comes from Bill Lewis from JP Morgan.

William Lewis, JP Morgan

Good afternoon. First, a clarification if I could, I think Tunc you said the bookings number was 570, was that correct or was it 510?

Tunc Delugha, Group President

It was actually 507.

Jack Gifford, Chairman, President and Chief Executive Officer

The bookings on us were 507. We have another number that is in-market bookings, these are bookings that our reps and distributors get from their customers, that number was $522 million, so they’ve booked more than they booked on us.

William Lewis, JP Morgan

Got it. And then my question I guess is about the changes you’ve made that you identified relative to complex products and gross margins, could you maybe talk about at what rates these benefits will start to layer in, when they’re going to start to benefit the company? And then also any implications to the wafer fab side of manufacturing? You talked about back end as a result of this bimodal product planning, impact o CapEx, and any change to your inventory model such as the way you think about dye banks and these types of products versus the less complex products.

Jack Gifford, Chairman, President and Chief Executive Officer

I didn’t address that because that was in the cost center for us, so it wasn’t a problem, and I tried to address the areas that we were going to attack and are attacking relative to setting ourselves up better to deal with these complex products that we’ve been successful with. So, to answer your first question in part, we’re already seeing the benefit of some of the things we said we’re doing, which would be like transferring products offshore for instance. We are also doing some things with pricing. We have raised pricing, which has had benefits, and I would think in the third quarter we’ll actually see some of the more immediate short-term things starting to roll through. Everything I’ve talked about the six areas of improvement, every one of those is going to have an intermediate effect and in some cases the short-term improvement.

William Lewis, JP Morgan

On the last part of that, does this at all change the way you think about dye bank and kind of the lasting quality of your inventory, do shorter product life cycles create new challenges there and new spending requirements?

Jack Gifford, Chairman, President and Chief Executive Officer

I don’t think so. It’s more dynamic. Things speed up, but I don’t think there’s any efficiencies associated with it.

William Lewis, JP Morgan

Okay, thanks.

Operator

Thank you. Our next question comes from Doug Freedman from AmTech Research.

Doug Freedman, AmTech Research

Thanks, AmTech Research. I think some of the questions are targeted at this, Jack, but if you could help us understand, where do you think you guys are right now in sort of a capacity expansion cycles that we tend to see, should we expect the CapEx to be rather stable going forward or if you can help us understand where you think you might be.

Jack Gifford, Chairman, President and Chief Executive Officer

Yeah, let me look at something before I answer that question.

Doug Freedman, AmTech Research

I guess I’ll give it in context. In thinking of a company on a longer term free cash flow basis, it’s important to understand really where that CapEx needs to be given to the growth goals.

Jack Gifford, Chairman, President and Chief Executive Officer

Well, in the quarter that we’re in right now, we’re going to produce about $16 million more, that means that capacity is in place and if we shipped all those and they were in mix, we would be able to ship $634 million in that quarter. We are running at about 75% of our fab capacity at that level and that’s installed capacity. Did that answer your question?

Doug Freedman, AmTech Research

My question really is given that you’re at 75% of your fab capacity and where you are in your spending, your CapEx spending, should we think that CapEx spending is not going to not be cyclical and it’ll be sort of a stable level as a percentage of sales or are we going to have another fab purchase that’s going to need to take place in a year or two and should we be thinking about a blip on the spending curve?

Jack Gifford, Chairman, President and Chief Executive Officer

Well, a number of questions there, but as I pointed out, we’re right now producing in the second quarter at rate, if the mix was perfect, and we would be able to ship about $2.3 billion to $2.4 billion, and we’ve got 25% more capacity than that. That’s a very gross rate but a very simple and actual way to look at that now. Having said that, we have to spend money today and we’re continuing to spend money in order to add fab capacity relative to our long range plan. We are spending money now and we’re going to expand our capacity another 10% in the existing facility. So, that would give us 10% more capacity. Now, having said that, we will have to acquire another fab certainly within the timeframe you outlined if we are to meet our plan.

Doug Freedman, AmTech Research

All right, that’s helpful. One other things mentioned was that you’re working on improving cycle times and can you go into any detail in what you’re doing there and how that’s going to be taking place and what impact that’s expected to have on your delivery performance and where you stand with delinquencies?

Jack Gifford, Chairman, President and Chief Executive Officer

Delinquencies are mostly due to booking out of mix rather than cycle times or capacity issues; in other words, we’ve built more than we shipped last quarter. We’ll probably build more this quarter than we’re going to ship, but the mix issue is the problem, and I don’t believe we’re that abnormal by the way, but at any rate it’s not a capacity problem and in my view it’s not a cycle time problem. Our cycle time is about 10 weeks right now…I mean it’s not our cycle time but our lead times are about 10 weeks. Our fab cycles are from very short to very long. We have processes that have 30-40 moves and they have a 20-day fab time and we have other processes that have 190 moves and they have a 100-day cycle time in fab. You’re not going to get around those kinds of numbers depending on the complexity of the process. All companies have pretty much the same assembly and test times and shipping times. The bigger issue frankly is knowing what to build and that is our biggest problem if I had to pick one, is the mix. It would be nice to have shorter cycle times but in order to do that you’ve got to have simpler processes.

Doug Freedman, AmTech Research

All right, thank you very much.

Operator

Thank you our next question comes from Sumit Dhanda from Banc of America Securities, your question please.

Sumit Dhanda, Banc of America Securities

Hi Jack. I wanted to first go back to I think a comment that Tunc made again about targeting the more complex chips and what it is as a percentage of revenues. My recollection is that in fiscal ’05 it was 15% and I think this indicated about 10% to 15% of revenues. So first of all, if that is correct then why the progress in terms of that metric being higher has been delayed here? That will be my first question.

Tunc Delugha, Group President

It’s 34, but I can’t exactly remember one, and I don’t remember the exact years but it was like 13%, 14%, and 15%.

Sumit Dhanda, Banc of America Securities

I think it was 14% in ’04 and 16% in ’05.

Tunc Delugha, Group President

So those numbers were right, I don’t have them in front of me so I can’t answer you. Whatever we presented there was correct.

Sumit Dhanda, Banc of America Securities

I guess my question is, why are the numbers — for lack of a better word — still depressed at 10% to 15%, is the benefit from the model changed so much slower material wise, and if that’s the case then how do we get conviction in 30% to 40% growth in this business?

Tunc Delugha, Group President

Yeah, when I said 10% to 15% I didn’t have the numbers in front of me, but if I remember the graph it’s definitely going up to the right.

Jack Gifford, Chairman, President and Chief Executive Officer

In terms of just throwing out a range, I mean if you want to be that precise we’ll get you the numbers here. We’re not changing those numbers.

Sumit Dhanda, Banc of America Securities

I guess the second question I have is, Jack, do you have an estimate of what consumption was this quarter, you give it out at times, is it close to what the distributor bookings were?

Jack Gifford, Chairman, President and Chief Executive Officer

Yeah I do. We think that consumption in the first quarter is about $526 million.

Sumit Dhanda, Banc of America Securities

And a couple of other housekeeping questions. I know you can’t comment on the progress on the options investigation, but the $3 million that you’re incurring in expenses, should we be thinking about modeling that for a quarter or two going out, can you give us a time limit on that?

Jack Gifford, Chairman, President and Chief Executive Officer

I hope not. I can’t comment on that.

Sumit Dhanda, Banc of America Securities

Let me just ask you in a different way, so your flat-to-down operating expense assumes that there’s no relief on this front, is that fair to assume here?

Jack Gifford, Chairman, President and Chief Executive Officer

The fact that we didn’t want to comment on below-the-line spending is probably tied to variable expenses like that.

Sumit Dhanda, Banc of America Securities

Okay, great. Then, one final question on the tax rate, this 2 percentage point jump sort of permanent so we should think about modeling about 34.7% tax rate going forward?

Carl Jasper, Vice President of Finance and Chief Financial Officer

Yes that R&D tax credit is not reinstated these are correct. If it does get reinstated you have a catch up in the quarter to reinstate it, then we will be up only1% for the year.

Sumit Dhanda, Banc of America Securities

One final question here, Jack, I don’t want to make the point, but I think on the last call you talked about probably getting better efficiency from your San Antonio fab in short order, is that still per plan or are you still seeing some erosion in your margins as it relates to…

Jack Gifford, Chairman, President and Chief Executive Officer

No, actually not. Our fabs, I didn’t comment on that, I probably should have. Our fabs in our end-of-line operation actually contributed about $4 million of increased overhead capture from the previous quarter, so they did much better.

Sumit Dhanda, Banc of America Securities

Okay, thank you very much.

Operator

Thank you. Our next question comes from Chris Caso for Friedman Billings Ramsey, your question please.

Chris Caso, Friedman Billings Ramsey

Hi thanks. Jack, I wonder if you can just expand on some comments you made on the industrial market, you talked about that slowing down perhaps a little more than you expected in the quarter, is that kind of in line with some of your earlier comments thinking that people were probably ordering ahead because of lead times or is there something else going on there?

Jack Gifford, Chairman, President and Chief Executive Officer

Well, I could give you some idea of which ones were the slowest in the markets. The ones that were up were actually the PDA market, the cellphone market, and set-top box market. The camera market was about flat. The ones that were down more dramatically that were big enough to be important in that last quarter were both networking datacom and industrial; telecom were down. Those were all down, no big numbers, storage was down but that’s not that a big number. So, industrial was the largest market and if you look at the amount it was down and the size of the market, it had the biggest impact on all of our markets.

Chris Casso, Friedman Billings Ramsey

And I guess as we go into the March quarter, I know it’s early to make predictions on that here, but typically you have more selling days than typically the best quarter for that market, do you think it’s a situation where customers have inventory to burn or there’s something fundamentally going on in those markets that just the markets are slower?

Jack Gifford, Chairman, President and Chief Executive Officer

You mean this quarter?

Chris Casso, Friedman Billings Ramsey

Well, I talk about going into next quarter, because I think typically this is still a slow quarter for industrial, right?

Jack Gifford, Chairman, President and Chief Executive Officer

I think that the last quarter is probably going to be the slowest quarter from my view. I mean I don’t think this quarter is going to be any slower than last quarter, and that’s my opinion.

Chris Caso, Friedman Billings Ramsey

Do you think the September quarter winds up being the slowest quarter going forward in this fiscal year?

Jack Gifford, Chairman, President and Chief Executive Officer

Yeah, I’m guessing like you, but the reason I’m guess is because I think I believe that the reason the last quarter was down was because it didn’t have anything to do with demand, it had to do with the over orders the quarter before that, and I believe that. So, our ship demand does not show last quarter being materially down from the fourth quarter ship demand, but the bookings were up big time in the fourth quarter and down big time in the first quarter.

Carl Jasper, Vice President of Finance and Chief Financial Officer

Yeah, I have several business units that really play heavily in the industrial market and I think the comments that are relevant are the following: first of all the comment that the bookings were down is accurate, and I think that’s attributable to the fact that we have a very significant peak in bookings in the fourth quarter. The second comment is that based on our survey of our end customers, I don’t think that the end consumption has gone down. I think it’s essentially neutral, so the end consumption is flat. The bookings were down primarily because bookings in the previous quarter were up excessively. And the other data point as well is, within that market we’re not seeing any excess inventory. I think it’s primarily a bookings phenomenon. I don’t know if I answered your question or not.

Chris Caso, Friedman Billings Ramsey

That was pretty good color. Just finally with respect to the inventory questions, do you think that’s fairly universal among your end markets and end customers that the inventory levels are in pretty good shape; I mean some others in your space have talked about some pockets in inventory, what can you guys weigh out on that?

Jack Gifford, Chairman, President and Chief Executive Officer

You may want to comment Tunc, because you guys have first hand information than I do.

Tunc Delugha, Group President

In the business unit that I oversee the general thought is that there is really not much of an inventory issue. The only potential exception is on the networking datacom market where I’ve got some business units reporting that there is really no inventory issue while others are reporting that there is excess inventory, but it’s a pretty small amount. It’s a small percentage of our overall revenues that’s impacted by that. So, overall, I’d say it’s not a major problem in my divisions, and that’s across the board, the only exception being the networking datacom space.

Chris Caso, Friedman Billings Ramsey

All right, great, thank you.

Tunc Delugha, Group President

In some of the other ones like in the notebook area and so on, I think the inventories at the manufacturers are fairly low.

Jack Gifford, Chairman, President and Chief Executive Officer

Yeah, I’m reviewing some of the comments we’ve got from various divisions and we don’t see anybody saying that they have excess inventories, so I think we’re all saying the same thing and we think it’s not an inventory issue situation out there.

Tunc Delugha, Group President

I just want to make sure that’s it clear about what I said or misstated previously on the highly integrated products. The number for ’06 that we presented was 18% and that’s an actual number. In going forward, in ’07 it’s 25 and in ’08 it’s 33, so that 33 percentage of sales are in highly integrated complex circuits.

Chris Caso, Friedman Billings Ramsey

So, you’re correcting a number you said earlier?

Tunc Delugha, Group President

Yes, 10% to 15% is what I said for this year. So, previously for the complex, highly integrated circuits I said our sales were about 10% to 15%, so the correct number for fiscal year ’06 is 18%, and going forward it’s 25% in ’07 and 33% in ’08.

Operator

Thank you. Our next question comes from Jeff Rosenberg from William Blair, you question please.

Jeff Rosenberg, William Blair

Hi, on the bookings commentary, on the last call I believe you said the bookings were weak in June and July and then when you revised your guidance for the quarter you had said that they had improved during the quarter but not as much as expected. Can you characterize what you said about September earlier relative to how weak they were exiting the fourth quarter and into the beginning of the first quarter?

Jack Gifford, Chairman, President and Chief Executive Officer

I think September was definitely weak and I think we don’t expect to see those kinds of months in this quarter, I don’t think.

Jeff Rosenberg, William Blair

Okay, and I guess I was just wondering given July was weak to start the first quarter and then September was weak, was October up over July given that you started last quarter weakly?

Jack Gifford, Chairman, President and Chief Executive Officer

I really don’t want to comment on October, because it’s a four-week deal and I don’t want to set expectations either way. Otherwise, we’ll have the same conversation next quarter.

Jeff Rosenberg, William Blair

A question on gross margin too, I mean you’ve given us the effect of the change of mix over the past couple quarters and looking at my numbers it looks like that’s responsible for about half of the cumulative gross margin decline we’ve seen over the past couple of quarters and I think you talked about some manufacturing variances being predominantly responsible for the rest of the decline and some changes that were being made to improve those variances, is there a point at which you would expect to see some improvement in gross margin because you’ve addressed the ramp of production and some of the issues with mispriced products that you talked about in recent quarters?

Jack Gifford, Chairman, President and Chief Executive Officer

First, to get manufacturing efficiencies, we have to continue to add revenue growth, but we did have a pickup in manufacturing profits in this quarter and we would have some next quarter. But, the other improvement in gross margins is going to come from the number of things I outlined when I was telling you about how we’re executing now and our status. We need to fundamentally do a better job on pricing our products, we need to make sure that we get products into production and ones that we’re putting into production for these opportunities are production worthy and they have a cost model when they get in and out, so when they get launched and developed, and we have to be sure that we’re realizing those cost models or we have to get to them sooner. Now those things we’re doing and some of those things we’re working on with products that are already in production. So, we will see improvements from these efforts.

Jeff Rosenberg, William Blair

But is that something that will take several quarters before we see any sort of offset to the mix shift that continues to recur or is it something that given some of them are in production or mispriced products that are already out there that it should happen as soon as you get revenue stability?

Jack Gifford, Chairman, President and Chief Executive Officer

Yeah, Jeff first of all the mix shift, let’s make sure we all understand our view of the mix shift is. Our mix shift has more to do with the fact that we did not book in some of the higher margin product areas rather than the fact that we’re overbooking in the lower margin areas. That’s our view of that. I mean the products that we’ve been focusing on here in terms of affecting our margins have actually booked pretty much to plan. The products that haven’t booked like the industrial market and some of that stuff, some of the data converters…now I don’t believe that we have a bad mix going here at all. I’m not worried about our plan in that regard. I think we have suffered from three things -- one is the execution of our costs, the second thing is pricing our products correctly, and then the third thing is we’re not booking in the mix of higher margin products that we had anticipated. So, those are all affecting our overall gross margins and I think that they’re not on a trend line, they’re more aberrational in my view. But, we’re doing a lot of things to put controls in to correct this trend that’s gone on for three quarters.

Jeff Rosenberg, William Blair

Okay, thank you.

Operator

Thank you. Our next questions comes from Craig Ellis from Citigroup, your question please.

Craig Ellis, Citigroup

Thank you. Using the gross margin backdrop where you’ve now got bimodal strategies that seem to be moderating the pace of gross margin decline as the complex mix shifts up over time, and we said maybe low 60%, what does that imply for operating margins, Jack? You recently talked about 44%, is that still the right number, is it closer to 40%?

Jack Gifford, Chairman, President and Chief Executive Officer

I don’t know if I ever said 44%, but 40% is what I’ve been talking about, and I’m not accurate enough to tell you how much above 40%, but our goal is to have operating margins above 40%. This is not non-GAAP.

Craig Ellis, Citigroup

Right, and then in the press release there was the mention of a manufacturing retention grant, what was that, was it for all facilities or select facilities?

Jack Gifford, Chairman, President and Chief Executive Officer

That was across the board. Fundamentally, there are issues that we give out to people, and I don’t know if retention is accurate as it needed to be, it was a grant given out to all employees based upon on our judgment of those people.

Craig Ellis, Citigroup

So, was that all manufacturing employees?

Jack Gifford, Chairman, President and Chief Executive Officer

It was everybody, it wasn’t retention in that we were giving it to people to keep them from leaving, and that’s what I’m trying to say.

Craig Ellis, Citigroup

Okay, got it. And then you talked about your strategy is intact for capital allocation, but can you give us capital expenditure dollars that we should expect this fiscal year and this current quarter?

Jack Gifford, Chairman, President and Chief Executive Officer

We’re looking at about $200 million for this fiscal year.

Craig Ellis, Citigroup

And split out front end versus back end there?

Jack Gifford, Chairman, President and Chief Executive Officer

It was about 65% fab and 35% back end.

Craig Ellis, Citigroup

All right, thanks guys.

Operator

Thank you. Our next question comes from David Wu from Global Crown Capital, your question please.

David Wu, Global Crown Capital

Jack, actually on the subject of the sufficiency measures that you’re putting in, I guess you mentioned that during the analyst day. When do you think you’ll be in full implementation stage? I guess these things get started, some already have gone out so you can’t do much about it, but new products you can do these things on. When roughly do you think it will take for the full implementation to be in effect? The reason I raise the question is that as the percentage of new complex products go up pretty sharply over the next couple years, are we doing enough things to catch the natural decline in the gross margins so that we can stop in the low 60’s or do we have do even more to stop that? I understand that there are blips like industrial hits this last quarter, which actually penalized your gross margin more than you would have guessed on a secular basis. I was just thinking about a trend line, how long do you think that these new measures have to take effect before we actually can get the efficiency to smooth out these bumps on the gross margin lines?

Jack Gifford, Chairman, President and Chief Executive Officer

Well, I think David there are two elements: one is products that are already announced, and they are affecting today’s revenue in gross margins. The other one, there is probably little less than 100 products that are in development now that are specifically managing so that they do not…these are complex products, 100 complex products, 93 to be precise, that we are managing that will not go out with unacceptable gross margins. That program was not in place when the current products were announced. So, our view is that we will not have products going out in the future beginning virtually now that are outliers that have…when I say gross margin problems I don’t mean that they are 50% gross margin or 55%, I mean that there maybe 15% or 20% gross margin issues, and they got out there because they shouldn’t have been introduced at the time. Those controls are in place. Getting to one repair, so to speak, that are out there is a bit more onerous and we’re doing what we can do. We’re reducing cost, we’re raising prices, we’re trying to control volumes and what have you. What we’re doing is already implemented. I think what you were really asking is when will you see an effect, and I think you’ll see effects going forward.

David Wu, Global Crown Capital

Well, of the current products, the percentage that Tunc mentioned was a pretty big number like 18% last year and 25% this fiscal year, obviously not all of these have got problems.

Jack Gifford, Chairman, President and Chief Executive Officer

That’s exactly right, and if we counted the products that we have that have problems that out there that are material, there’s about 20.

David Wu, Global Crown Capital

How big a percentage of revenue is that?

Jack Gifford, Chairman, President and Chief Executive Officer

Those 20 products is about $70 million.

David Wu, Global Crown Capital

Annual runrate I assume?

Jack Gifford, Chairman, President and Chief Executive Officer

For a quarter.

David Wu, Global Crown Capital

So, these are the problem child issues and you’ve been either to raise prices or they sort of died a natural death?

Jack Gifford, Chairman, President and Chief Executive Officer

No, there are three things, they will raise price, they will die a natural death or we will improve the yields, improve the costs, and that’s what we’re working furiously on, all two of those phases. But to give you some idea, we have actually on two or three of those products raised prices to the point where we killed the products. We have done it, so we’re deadly serious about this David.

David Wu, Global Crown Capital

Jack, I was wondering about these rapid grants, how long do you think it will take you to…but if you’re in a consumer product and you get these big Japanese and Korean customers, they demand extremely high ramp rates and they ramp down just as fast as they ramp up, and I was wondering, how far are you in this process of adjusting to those ramps?

Jack Gifford, Chairman, President and Chief Executive Officer

First of all let me comment on it. This is the market. If you ask TI or anybody that’s a material or an important player in the integrated circuit business, you’ve got to be doing business, you want to be doing business in these situations, you want these problems. The problems which we have are that we haven’t managed the profitability and the production reproducibility of these products consistent with these ramp rates, and we know how to do that; I mean we’ve recently obviously learned what we have to do, but we need to put these products into production so that they can ramp and they can ramp up profitably. I don’t know, maybe you have ask me your question again because I kind of rambled on there.

David Wu, Global Crown Capital

Okay, we all understand what the process is and all that good stuff, what I guess I was trying to ask you is, how far are we in a learning curve of adapting Maxim’s manufacturing operation to these kinds of products, rapid ramp up and rapid run down?

Jack Gifford, Chairman, President and Chief Executive Officer

Okay, call it a learning curve if you will, but we learned pretty fast. I mean it’s not any fun to have one of these things go into production and have 30% gross margins and have to build $3 million a quarter of them. They don’t have to teach you that lesson very many times, so I think we’ve learned the damn lessons. I mean I don’t we’re going to sit here and do this anymore. You might want to comment on that Tunc?

Tunc Delugha, Group President

I agree with Jack, I mean you’re hearing about some of the problem products, and we actually have ramped a lot of products and haven’t had a problem in the past. It’s not like we’re doing this the first time. On a few products and especially when we were in new technologies, we had this issue.

Jack Gifford, Chairman, President and Chief Executive Officer

That’s a good point, I mean he’s absolutely correct. We have had these issues in isolated areas. Like we said, the total number of problem products is 20 and the ones that fall into area are less than 20, but we have ramped a lot of products successfully, but we want to ramp them all successfully and that’s what we fix so that doesn’t happen anymore.

David Wu, Global Crown Capital

Fine. I guess the other thing I just want clarification on were some previous comments you folks made. If we look at the end markets they haven’t really dropped, and if we look at the world economy, that’s hasn’t gone down the tube either. So, the kind of things that we’re going through are the sort of things we went through a couple of times in the past, lead time adjustment by customers based on your delivery lead times, is that correct, and it sounded like we got probably another 90 days to go before this thing is ironed out?

Jack Gifford, Chairman, President and Chief Executive Officer

That’s right David, I agree with what you said but I don’t agree that it’s isolated to Maxim. We’re not the only company that had a fall off in bookings in the first quarter, and my view of that is if it’s our lead times that caused that, everybody had a lead time problem. I think it’s more the case of these customers actually over ordering in the fourth quarter, and we’ll argue that our lead times went out, so that could have even exaggerated it some, but all the companies that I’m aware of had a lack of bookings in the first quarter and I think it’s because of the high bookings that they and we had in the fourth quarter.

David Wu, Global Crown Capital

Yeah, you’re not unique.

Jack Gifford, Chairman, President and Chief Executive Officer

I mean, if you remember, we have good backlogs and it’s a mix issue as far as shipping dollars, but we’ve probably done as well as anybody has, so I don’t want to single this out for undue punishment.

David Wu, Global Crown Capital

No, I didn’t mean that, but it sounded like there are general comments by different companies that they’re going through this sort of thing, that it’s probably a six-month affair.

Jack Gifford, Chairman, President and Chief Executive Officer

Okay, I’m not of that opinion yet, I’m not sure of that. I don’t think it’s an inventory correction problem, I guess that’s where I’m coming from.

David Wu, Global Crown Capital

What the difference between lead time adjustment and inventory problem?

Jack Gifford, Chairman, President and Chief Executive Officer

Well lead time adjustment is they place orders on you…they don’t have inventory because you haven’t shipped the orders yet. It’s not like we over shipped in or over shipped orders, at least we did not, but we don’t think there’s any inventory out there; I mean it’s not an inventory with Maxim.

David Wu, Global Crown Capital

I see the difference, thank you very much.

Operator

Thank you. Our next question comes from Katlyn Wilford, your question please. If your phone is muted please un-mute it. Perhaps we just have to wait for that call. Our next question comes from Louis Gerhardy from Morgan Stanley, your question please.

Louis Gerhardy, Morgan Stanley

Good afternoon. You’ve answered a lot questions here, I just wanted to clarify my understanding of a couple issues. On the inventory front, are you saying that in some areas you have too much inventory and in other areas you have too little, and if that’s right in the areas where you have too little, can you give us maybe a little more of a granular sense on what some of the specific products are or maybe end markets, however you can answer that?

Jack Gifford, Chairman, President and Chief Executive Officer

Well, Louis, you analysis is correct. In some areas we had too much inventory and in some areas, where we booked, we didn’t have enough inventory, that’s accurate. Where we had not enough, it’s in areas obviously with new products, and they didn’t run a ramp in production. The forecast what we booked was more than anticipated and we either didn’t have the capacity or the yields to support them, but it’s as much a customer forecasting issue as it is Maxim’s issue frankly. These areas were notebooks, cameras, cellphones, it had to do more with the newness of the product and the lack of that accurate projection for it.

Louis Gerhardy, Morgan Stanley

And more of the complex products then?

Jack Gifford, Chairman, President and Chief Executive Officer

I don’t know. Tunc, do you guys want to comment on this?

Tunc Delugha, Group President

I think it depends, I wouldn’t say that, I mean they are more visible because they are big, but there are bunch of small products too.

Louis Gerhardy, Morgan Stanley

Okay, and then just to understand on the comment about 50 basis points drop in gross margin next quarter, is it fair right now to say most of that drop would be mix driven because you don’t yet know how much of an inventory reserve you’ll need to take?

Jack Gifford, Chairman, President and Chief Executive Officer

That’s correct, Louis.

Louis Gerhardy, Morgan Stanley

Okay, and do you have just a thought on your AR DSOs in the December quarter, if that would go up or down or flat?

Carl Jasper, Vice President of Finance and Chief Financial Officer

I would expect that number to be relatively flat.

Louis Gerhardy, Morgan Stanley

Okay, that’s all I have, thank you.

Operator

Thank you. Our next question comes from Ross Seymore from Deutsche Bank, your question please.

Ross Seymore, Deutsche Bank

Thank guys, a lot of questions have been asked, so I’ll try to make these quick. On the roughly 15% of revenues that you talked about with $70 million per quarter from the kind of 20-problem child areas, how do I compare that 15% to the 18% that Tunc clarified before, if I look at it just straight up it looks like 15%?

Jack Gifford, Chairman, President and Chief Executive Officer

First of all they’re not the same numbers at all. Tunc’s 18% is the high integration product…Tunc said our revenue from high integration product is 18%. I said that we got 20 products that produced about $70 million in revenues that had about a 2% to 3% reduction on gross margins, and not to say that it’s the same 18%.

Ross Seymore, Deutsche Bank

Okay, so they’re not across all the products, they’re a blend.

Jack Gifford, Chairman, President and Chief Executive Officer

They’re a blend, absolutely.

Ross Seymore, Deutsche Bank

Okay, that helps. And you kind of mentioned about the 2% to 3%, if I think about year-over-year on kind of a non-GAAP basis your gross margin has dropped about 5 points. The fixes you’re putting in place to improve the cycle times, get things offshore in they backend quicker, those sorts of things, how many points out of the five dropped do you think you could have avoided had you had this fix in place earlier?

Jack Gifford, Chairman, President and Chief Executive Officer

Well, I’m going to give you the same number. The number I know is that we have $70 million worth of products that dropped our gross margin by 3 points.

Ross Seymore, Deutsche Bank

Okay, so three out of the five, that’s fair enough.

Jack Gifford, Chairman, President and Chief Executive Officer

And if I took that to zero, that 3% would go away, so I’d have $70 million per quarter less revenue.

Ross Seymore, Deutsche Bank

Okay and then the final question, you spent a lot and valuable time talking about what you’re going to do to improve the gross margin. On the OpEx side of things, does that sort of cost discipline fall through? I know you’re a big believer in investing for the future and that that’s necessary for your growth. If I look to the last rough patch that we went through, it looked like your OpEx grew right through that. What would it take to have OpEx either remain flat or go down, or is it one of those things that you just want to invest for the future?

Jack Gifford, Chairman, President and Chief Executive Officer

Is the question on we going to increase our operating expense?

Ross Seymore, Deutsche Bank

What would it take for OpEx to come down, you’re focusing a lot on gross margin, is there something that you believe you can do on the OpEx side or are you completely comfortable with the investments you’re making there?

Jack Gifford, Chairman, President and Chief Executive Officer

Yeah, we’re not planning to reduce our below-the-line spending. I’m not sure I’m following your question Ross. Do you want to handle that?

Ross Seymore, Deutsche Bank

May another way to put it. If things remain tough from a bookings perspective heading into the first quarter, do you believe that actions could be taken on the OpEx side of things?

Jack Gifford, Chairman, President and Chief Executive Officer

We did do some things in the second quarter to moderate some of the below-the-line spending, but the fact in the first quarter we hired 102 engineers and in this quarter we’ll probably reduce that hiring plan materially in this quarter. Short of knowing what’s going to happen with bookings, I mean that’s a very day-to-day thing and we could change that thought tomorrow if bookings pick back up, but we are controlling spending right now, Ross, if that’s your question.

Ross Seymore, Deutsche Bank

Yeah, that was basically what I got.

Jack Gifford, Chairman, President and Chief Executive Officer

We are definitely controlling spending until we see how this quarter’s bookings go.

Ross Seymore, Deutsche Bank

Perfect, thank you.

Operator

Thank you. Our next question comes from Tore Svanberg from Piper Jaffray, your question please.

Tore Svanberg, Piper Jaffray

Yes, good afternoon, a couple of questions. First of all, there are a lot of questions on the high integrated products, could you just remind me why it’s so important to track that percentage, it doesn’t seem like it impacts gross margins, I’m just wondering why that’s so important.

Jack Gifford, Chairman, President and Chief Executive Officer

We pointed out why it’s important that we need to manage them differently, that’s one of the reasons we track them. We need to manage their execution more carefully and at higher levels both internally with Maxim and with the customer. And for us to track the percentage I think that number was generated because we wanted to tell you how much of our effort was going in that direction.

Tore Svanberg, Piper Jaffray

Okay. The other question is, it seems like every time we get to one or two quarters with double digits, sequential increases in bookings, two or there quarters later we see a decline in bookings. Do you think that’s sort of what the rule of the world is these days or any reason to think otherwise?

Jack Gifford, Chairman, President and Chief Executive Officer

I can’t answer that question any better than the rest of us here or you. I think bookings are modulated by excess inventories and by customer expectations. When they believe things are going good for them, they book heavily and when they’re a little concerned, they back off, and if they get inventories they back off further. But I think it’s relatively normal to have a down quarter every few quarters. As you point out, historically it happens so it must be normal.

Tore Svanberg, Piper Jaffray

It’s just that they used to be more sustainable before, that’s okay. The final question is…

Jack Gifford, Chairman, President and Chief Executive Officer

Let me say one more thing. In our business I think two things are going on: one is they’re operating with less capacity and they are less willing to waste inventories, so I think you find supply less available today than you maybe did in the past, and therefore you find customers that are more aggressive in order to get supply; I mean we were hearing last quarter to a quarter and a half ago about the fabs where the foundries were on allocation and the assembly houses were on allocation. So, I think that there’s more volatility in the supply side.

Tore Svanberg, Piper Jaffray

And that’s also why bookings from a percent probably are less relevant now than what they used to be. The other question I had is on visibility. I know you can’t comment on the first half or the March quarter, but when do you start to get a feel of whether that’s going to be a good quarter or not, could you start to see some of those signs towards the end of the year or do we have to wait until January?

Jack Gifford, Chairman, President and Chief Executive Officer

In the quarter, we’re in?

Tore Svanberg, Piper Jaffray

No, I’m thinking about the March quarter, so do we have wait until January before we get a good feel about that quarter or could you start to see some signs already in November or December?

Jack Gifford, Chairman, President and Chief Executive Officer

We have no idea, Tore. When we saw the size of the fourth quarter bookings I think everybody said “Jesus, is this going to tell us that the next quarter is down or slower.” I mean in hindsight you could clearly come to that conclusion. I have no way to predict what the March is going to be other than our shipped demand, and our shipped demand forecast projects that there is going to be growth in the coming quarters.

Tore Svanberg, Piper Jaffray

Okay, and last question. You talked a lot about mix and I understand that’s very important, but is it also safe to say that it’s not a Maxim’s execution problem but it’s also end market based where a lot of the units being driven in the last couple of quarters has been lower ASP units?

Jack Gifford, Chairman, President and Chief Executive Officer

Mix is mostly due to the fact that we didn’t book the right mix of the high margin stuff, and then the other issue is the stuff that we did book, some of it had cost problems.

Tore Svanberg, Piper Jaffray

Okay, so there was actually a demand for those high margin products but you just weren’t there at the right time?

Jack Gifford, Chairman, President and Chief Executive Officer

No, there has been a slow down; I mean last quarter bookings on higher margin products slowed down.

Tore Svanberg, Piper Jaffray

And that’s my point, it’s not something necessarily you can control, it’s more the end markets, especially areas like communication and industrial slowing down.

Jack Gifford, Chairman, President and Chief Executive Officer

Controlling is our responsibility, I guess…

Tore Svanberg, Piper Jaffray

No, I’m just trying to understand where the issue is coming from, but that’s fair, thanks a lot Jack.

Operator

Thank you. Our next question comes from Ramesh Misra from CE Unterberg.

Ramesh Misra, CE Unterberg

Good afternoon, Jack. My question was related to industrial, and I’m sorry if I’m asking for stuff you might have already said before, how much was it in the quarter very roughly, and without looking into guidance for the first half of next year, traditionally that’s been a business area that tends to pick up for you, fundamentally or on a secular basis are there any signs why you should not seeing that this time around?

Jack Gifford, Chairman, President and Chief Executive Officer

See what this time around?

Ramesh Misra, CE Unterberg

Strength in industrial in the first half of ’07.

Jack Gifford, Chairman, President and Chief Executive Officer

Well, industrial went up from the second quarter to the fourth quarter of ’06, we had 20% growth in industrial, and the industrial market dropped was off 18% or 19% this quarter. I think that was due to overbooking maybe in the third quarter and fourth quarter, but I can’t prove that, I don’t have any basis for that, I mean I don’t know what the second quarter is going to look like in industrial, and I don’t have any way to answer your question actually.

Ramesh Misra, CE Unterberg

Okay, I think in the past the automated test equipment arena had been an important part of your business, is that still a fairly important portion of your business?

Jack Gifford, Chairman, President and Chief Executive Officer

It’s really not that big. We may have mislead you there, you know the automated test portion of our business is 2% or 3% of our business, so it’s not very big, and it was down 8% or 9% last quarter, but it’s not a big percentage of our business.

Ramesh Misra, CE Unterberg

Okay, great, that’s all that I had, thanks.

Operator

Thank you. Our final question is a followup from Sumit Dhanda from Banc of America Securities.

Sumit Dhanda, Banc of America Securities

Jack, I had a question on the issue as it relates to mix versus the bookings that you’re getting from your customers. I want to understand really what is the big challenge there especially given your comment that it wasn’t only relegated to the newer more complex products, I mean you’ve been involved in the standard analog business for a while, what has really changed in terms of the issue of forecasting?

Jack Gifford, Chairman, President and Chief Executive Officer

Well, what’s changed is the idea of general purpose products that many, many customers use, so there’s an averaging effect when you build product. If somebody doesn’t buy, somebody else will. Most of the products today whether they’re complex or simple are application specific, so if there aren’t not 10,000 customers there maybe 3 or 4 customer or 5 customers for that particular product. And when they predict incorrectly what they need, you get designed in and they now go into production, like the iPods I told you before…I’m using iPod just as a name, it’s not the real story, not really the Apple iPod…but these products are projected to be 500,000 a quarter opportunity and they end up being 3 million, and that’s a real example. I mean these customers just don’t know. All of the Japanese companies, anybody that’s in a consumer related business, retail business including the notebook computer guys, they don’t have a good idea of what their consumption is going to be. So, if you’re not able to ramp that product or have excess inventory of it, you can’t respond. Short of having a general purpose product that you just build and put an inventory and thousands of companies use the same device, you’re going to have these out of mix issues. We may talk about them more than others, but these are not unique to Maxim.

Sumit Dhanda, Banc of America Securities

Okay, thank you very much.

Operator

Thank you. There are no further questions in the queue at this time, I’d like to turn the program back to you.

Carl Jasper, Vice President of Finance and Chief Financial Officer

Thank you, operator. Well, this concludes Maxim’s conference call and we would like to thank you for your continued participation and interest in Maxim.

Operator

Thank you ladies and gentlemen for your participation in today’s conference. This does conclude the program, you may now disconnect, good day.

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Source: Maxim Integrated Products F1Q07 (Qtr End 09/23/06) Earnings Call Transcript
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